Keep Your Portfolio Safe In A Recession
One sector of the economy seeing increased capital inflows is the utilities sector. While segments like energy, materials, industrials, financials, and others are well off their highs, utilities are in a solid uptrend, trading around new all-time highs.
With an economic downturn emerging on the horizon, utilities are in a favorable market position relative to other sectors in the economy. Therefore, their recent outperformance should continue going forward.
I've been on a quest to "recession proof" my portfolio since 2018 began. I've extended my gold related holdings, I've introduced a healthcare segment, and I increased positions in defensive dividend stocks. Next, I want to add several high-quality utility stocks that should further reduce volatility, increase yield, and add a supplementary layer of stability and safety to my portfolio.
What's Behind the Outperformance?
Utilities are up by about 13.5% since the December lows and are up by about 17% over the past year. This is compared to an S&P 500 that's up by only around 4% and a Nasdaq composite that's up by only around 3% over the past year. In fact, out of the 11 major sectors in the U.S. economy, utilities have been the best performing sector by far over the last year.
So, what is behind this substantial outperformance? Utility stocks are in high demand and they are in demand for several reasons.
First, utilities are great in times of an economic slowdown, as everyone needs electricity and water, and essentially no matter what happens in the economy most people will continue to pay for these basic utilities.
Second, utilities are basically natural monopolies, implying that in many cases there are no direct competitors to provide these basic but crucial services. Thus, utilities are largely immune from softening sales, demand issues, price volatility, and competition.
Third, many utilities, in conjunction with their steady revenues and earnings streams, provide stable, sizeable, and often expanding dividends. Most of the quality utility names I've looked at and considered for my portfolio pay very safe and stable 3-4% annual dividends.
Here are 3 utility plays I am considering for my portfolio:
1. AES Corporation (AES) generates and distributes electrical power across more than a dozen countries. The company recently underwent a large-scale reorganization of its business aimed at trimming costs. AES has also been shifting more towards solar and other sustainable solutions with its acquisition of sPower in 2017.
AES has a market cap of around $12 billion, trades at only about 12.62 times next year's consensus EPS estimates, and provides a dividend of around 3%.
AES is an extremely strong uptrend, and the stock is up by around 75% over the last year. Despite the likelihood for a short-term pullback in the shares, AES is likely to outperform the market longer term.
2. FirstEnergy Corp. (FE) services roughly 6 million customers throughout states like Ohio, Pennsylvania, West Virginia, and others. FE has a market cap of around $22 billion, trades at roughly 16 times next year's consensus earnings estimates, and pays out a dividend of about 3.7%.
The technical image is also very strong with FE, as the stock is in a very firm uptrend, up by about 30% over the past year. Like with AES, while shares appear a bit overbought on a short-term technical basis, longer term, this stock is likely to outperform the market.
3. Utilities Select Sector SPDR ETF (XLU) is an ETF comprised of various U.S. utility companies. The fund has 29 holdings, with the top 10 making up 61% of the weight. The fund's top holdings include NextEra Energy (NEE), Duke Energy (DUK), Dominion Energy (D), Southern Company (SO), and Exelon Corp. (EXC). These 5 holdings alone account for more than 40% of the ETF's weight. The weighted average market cap in the fund is about $39.6 billion, the average P/E ratio is around 21, and the fund yields a dividend of about 3%.
We see that XLU has been in a very strong uptrend over the last several years and this advance should continue going forward. As the economy slows, market conditions should continue to push market participants towards the stability, safety, and yield utilities offer.
Utilities Vs. Other Sectors
To get an image of the utilities sector's performance vs. other segments in the economy, let's take a closer look. Looking at sector performance over the past year, we see that utilities are performing quite well.
Over the past year:
- Utilities: up by 16.6%
- Materials: down by 5.2%
- Communication: up by 2.3%
- Technology: up by 6.4%
- Industrials: down by 2.5%
- Healthcare: up by 8.3%
- Financials: down by 7.5%
- Energy: down by 1.6%
- Consumer staples: up by 4.2%
- Consumer discretionary: up by 5.2%
- Real estate: up by 14.6%
I want to highlight that there are just two sectors that are up by double digits over the last year and that's the two most defensive sectors real estate and utilities. Moreover, both sectors are trading around new all-time highs, whereas more cyclical sectors like industrials, energy, and others have underperformed, some very notably since their recent highs.
Even areas like technology and financials aren't looking particularly good. In fact, financials are the worst performing sector over the last year with a loss of 7.5%. Typically, notable underperformance in financials is an alarm bell that not all is well with the economy.
Another noticeable factor is healthcare's outperformance (also a defensive segment), up by 8.3% over the last year, the third best performing sector behind utilities and real estate. Clear outperformance in the most defensive segments of the economy is likely a warning sign that a slowdown or possibly even a recession is approaching.
Just looking at the recent sector performance should give market participants pause over the likely future performance of the economy. We clearly have the most defensive sectors leading now, with some of the most cyclical segments (materials, industrials, financials, energy), in negative territory over the past year.
This type of price action is indicative of a market that is in the very late stages of an economic cycle. When defensive names start to substantially outperform cyclical stocks, it indicates that market participants are selling stocks that are tethered to the wellbeing of the economy and are accumulating stocks that are likely to withstand a market downturn.
Should You Buy Utilities Today?
While utilities should continue to outperform going forward, this may not be the most optimal time to step in. The utilities sector is quite overbought right now, both on a fundamental and on a technical basis.
For instance, NextEra, the largest holding in XLU is trading at a forward P/E ratio of 21, which is not exactly cheap, especially for a utilities stock. Other companies in this sector trade at similar multiples, which are slightly to moderately elevated in my view.
Additionally, the technical image is quite overheated, as XLU is currently trading with an RSI of 81.56, implying a pullback is very likely to occur quite soon. Other technical indicators like the CCI, full stochastic, and others are also suggestive of an upcoming pullback in the utilities segment.
Thus, when the pullback arrives, I will use it as a buying opportunity to build exposure to utility stocks. Anything from a 5-10% pullback should be viewed as a substantially buying opportunity going forward in my view.
A question market participants should ask is, why utilities are in such high demand right now? And the answer goes back to the search for safety, stability, and yield. Market participants continue to rotate from the more aggressive and cyclical segments of the economy to more defensive sectors like utilities, real estate, and healthcare. This is another clear warning sign that the economy and the stock market are very likely approaching a top.
The Bottom Line
Utilities are hot right now. In fact, utilities are the best performing sector over the past year. And it's not just utilities, real estate, and other defensive segments of the economy have been outperforming the market lately.
Why are these sectors outperforming? The recession or a significant market downturn is likely approaching and investors are rotating away from cyclicals and are showing increased interest in sectors that provide stability, perceived safety, and yield. This trend is likely to continue, and longer-term, utilities should continue to receive increased interest and should continue to outperform the broader market.
Nevertheless, this sector is quite overbought right now and a pullback is likely to occur soon. Investors should use the upcoming pullback as a buying opportunity in the utilities segment. Two specific stocks market participants should look at are AES Corporation and FirstEnergy Corp. Also, investors could consider XLU, a utilities ETF comprised of 29 separate holdings.
Collectively, utilities should do relatively well going forward as demand should continue to be strong for stocks and sectors that provide stability, "safety", and yield in a slowing economic environment.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article expresses solely my opinions, is produced for informational purposes only and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please consider consulting a professional before putting any capital at risk.